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Consulting

The Realities for the Worlds Largest Organizations

April 2005

Calling a Change inthe Outsourcing Market

Audit .Tax .Consulting .Financial Advisory.


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Table of Contents

Executive Summary .................................................................... 2

Market Situation .........................................................................4

Structural Risks............................................................................ 8

Costs ...........................................................................................13

Organizational Complexity ...................................................... 18

Conclusions ................................................................................22

Appendix

Literature Sentiment Index ..................................................... 27

Analysis of Problem Deals ...................................................... 28


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While outsourcing has become a dominant trend, emerging evidence indicates that results havebeen mixed, and there are few in-depth studies that can help senior executives recognize the

inherent complexities and common pitfalls of outsourcing. Deloitte Consulting LLP conducted astudy to help fill this gap and provide a fresh point of view on outsourcing.


1

Deloitte Consultings approach consisted of an in-depth study

of current outsourcing strategies, their impact on

organizational performance, and nascent outsourcing trends.

The participants represent 25 world-class organizations in

Manufacturing, Transportation, Consumer Business, Energy,

Financial Services,Technology/Media/Telecommunications,

Health Care and the Public Sector.

Nearly half of the participants are part of the Fortune 500;

one-fourth are privately held or public sector entities and four

are headquartered outside the United States. Six are part of

the Fortune 50, and three are ranked in Fortune Global 100.

Approximately three-fourths of the participating organizations

are listed on the New York Stock Exchange or NASDAQ.

Ten participants are members of the Dow Jones Composite

Index and/or the Standard & Poors 500.

These organizations represent a combined market

capitalization of nearly 1 trillion USD, employing more than1 million workers. They spend a combined 50 billion USD on

their large outsourcing contracts alone.

The average participant has annual revenues of 50 billion

USD, operating expenses of 13 billion USD, market

capitalization of 53 billion USD, and approximately 60,000

employees.

Two notable academics, Dr. N. Venkatraman (Boston

University) and Dr. Eric Clemons (University of Pennsylvania,

Wharton School of Business), also participated in the study.

The study was conducted in-person during October

December 2004 with senior executives who have both

decision-making and operational authority in outsourcing in

their organizations.

Comments contained in the findings and analysis that follow

have not been attributed to study participants to maintain

confidentiality. Not all participants answered all study

questions.

Throughout this document, the words companies and

organizations have been used interchangeably to denote

entities outsourcing business functions. Outsourcing providers

are denoted as vendors.

No part of this publication may be reproduced, stored in any

retrieval system, or distributed in any form or by any means

without the prior written permission of Deloitte & ToucheUSA LLP.


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Organizations have now begun to recognize the real costs and

inherent risks of outsourcing. Instead of simplifying

operations, outsourcing often introduces complexity,

increased cost, and friction into the value chain, requiring

more senior management attention and deeper management

skills than anticipated. In addition, outsourcing has allowed

organizations to transfer financial and operational risk to

vendors, but organizations are discovering that their contracts

will never fully protect them against customer damage and

business losses caused by service disruption. Many have

responded by bringing operations back in-house and by

exploring alternatives to traditional outsourcing, such as the

Transform-Operate-Transfer model.

Forced to globalize and meet client demands for closer

working relationships, vendors face significant challenges,

including the prospect of diminishing profit margins. Based on

the evidence from our research, Deloitte Consulting is calling

a change in the outsourcing market.

Executive Summary

Outsourcing is an extraordinarily complex

process, and the anticipated benefits often

fail to materialize.

Based on the evidence from our research,

Deloitte Consulting is calling a change

in the outsourcing market.

The worlds largest companies have engaged in outsourcing for a variety of reasons: to reducecosts, expand capabilities, and increase flexibility. However, contrary to the optimistic portrayalof outsourcing by vendors and the marketplace, outsourcing is an extraordinarily complexprocess and the anticipated benefits often fail to materialize.

The outsourcing of services requires a complex series of trade-

offs: cost savings versus growth, speed versus quality of

service delivery, and maintaining organizational cohesion

versus knowledge and innovation. Vendors and organizations

have inherently conflicting objectives, putting the latters

objective for innovation, cost savings, and quality at risk.

Moreover, the vendors structural advantages do not always

translate into cheaper, better, or faster services. The worlds

largest companies should be able to replicate the vendors

structural advantages in-house and rely on vendors only under

specific circumstances, such as fixing deep-seated structural

problems or maintaining infrastructure operations.

Outsourcing originated and became popular as a cost-saving

strategy during a recessionary environment. The worlds

largest organizations in this study are calling into question its

efficacy in todays economy.


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In the near future, with structural risks that

cannot be fully mitigated, uncertain cost

savings, and a multitude of components tomanage, outsourcing will likely lose luster

for large organizations.

In todays economy and labor market, organizations looking

for differentiated growth solutions should avoid outsourcing

when based solely on cost savings. Many organizations have

been compelled to adopt outsourcing to improve theirtechnical, operational, and process management skills.

However, companies should outsource only commodity

functions to guard against a loss of knowledge and should

plan for short-term outsourcing to prevent vendor

dependency. Demanding transparency to costs, negotiating

for simplicity to eliminate hidden charges, and actively

managing against service disruptions may improve the

outsourcing experience for large companiesbut in turn they

also will increase the time needed to manage the complexity

and costs of these arrangements.

In the near future, with structural risks that cannot be fully

mitigated, uncertain cost savings, and a multitude ofcomponents to manage (people, process, and knowledge),

outsourcing will likely lose luster for large organizations.

An unfavorable mix of rising costs and increased demand will

drive up the cost of outsourcing for organizations and

vendors. Weaknesses in operational management will result in

more deal failures, prompting organizations to bring more

operations back in-house. In the long run, organizations that

continue to outsource will experience a loss of bargaining

power to vendors as the supply side consolidates.

Those that apply strong skills in deal structuring and risk

management and strong management skills to oversee dealsfrom inception to execution will be best positioned to reap the

benefits of outsourcing. Deloitte Consultings point of view is

that outsourcing will remain a useful solution within the

conservative context of five models: Centralize-Standardize-

Outsource, Transform-Operate-Transfer, Commodities

Outsourcing, Risk Transfer (Insurance), and Shifting Fixed

Costs to Variable Costs.


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In the real world, outsourcing frequently fails

to deliver its promise.

Rising negative sentiment in the media,

analysis of a sample of 50 problem deals, and

other surveys prove that the tide is turning in

the outsourcing market.

Large organizations are managing margins

and demanding more from vendors, butlarge-scale insourcing and reduced choice of

providers will erode the allure of

outsourcing.

Market Situation

4


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The Rationale for Outsourcing Is at Odds with Market Experience

Source: Deloitte Consulting Outsourcing Study, October-December 2004

Cost Savings

Best Practices/Quality/Innovation 57%

Flexibility/Capacity/Scalability

35%

Focus onCore/Strategic

Access to High-Caliber Labor

22%

Transfer Riskto Vendor

*Participants were not limited to one answer

70%

35%

22%

Lack of ExpertiseIn-House

16%

Each participant named at least one of the items belowas a major driver of the outsourcing decision

However, in many cases, the participants outsourcing experienceshave not measured up to their expectations

but 38% of these participants have paid additional/hidden costs for services theybelieved were included in their contracts

but 31% of these participants stated vendors became complacent once contractswere in place

but commentary revealed that outsourcing adds a level of rigidity becausecontracts are binding and vendors may choose not to accommodate last-minute

changes or requests

but 1 in 4 of these participants had mislabeled functions as non-strategic andultimately brought those thought leadership areas back in-house

but 1 in 5 of these participants experienced greater than expected vendoremployee turnover and realized the knowledge base they had paid for was fleeting

but commentary revealed that vendors are unable to fully absorb the costs ofbusiness losses, leaving the organization responsible for paying the bill

but 44% of these participants found that their vendors did not have the capabilitiesto provide the expected level of quality and cost savings, resulting in the participantsdecision to bring operations back in-house

The worlds largest companies should be

able to replicate the vendors structural

advantages in-house and rely on vendors

only under specific circumstances.

In the Real World, Outsourcing Frequently Fails to Deliver Its Promise.


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Negative articles are outpacing the positive.

30 percent more anti-outsourcing articles (55) than pro-

outsourcing (42) ones were published in 2004.1

For the first time, thenumber of anti-outsourcing articles

has surpassed the number of pro-outsourcing articles in

the sixsampled publications.

In a 2004 LexisNexissearch, occurrences of 13 stock

phrases2denoting negative outsourcing sentiment exceeded

all such occurrences in the last five years combined.

Source: Business Week, The Economist, Forbes, Fortune, The Wall Street Journal,and The Washington Post

120

100

80

60

40

20

01999 2000 2001 2002 2003 2004

Year Through 12/15/04

Pro-Outsourcing Articles

Balanced

Anti-Outsourcing Articles

Informative

Number

of Articles

In the past eight years, 38 of 50 randomly selected

problem deals, totalling more than 25 billion USD,

resulted in litigation or termination.

From the sample of 50 problem deals, 74 percent failed due

to vendor underperformance and/or cost overruns.

Of the 33 deals in the sample for which the timing is

known, one-third failed in the first year, and50 percent in

the first five years.

Outcome of 50 Problem Deals

Source: Randomly Chosen 50 Problematic Outsourcing Deals from LexisNexis ,Factiva and Proquest

Litigation32%

DealTermination

44%

Deal at Risk20%

NegotiationsCalled Off

4%

Other surveys also debunk the optimistic portrayal of

outsourcing by vendors.

A Dun & Bradstreet Survey3shows 20 percent of

outsourcing relationships fail in the first two years, and 50

percent within five years.

A DiamondCluster International Survey4

shows that 78percent of responding executives had to terminate

agreements early due to poor service, a change in strategic

direction, or costs.

A PA Consulting Group Survey5of executives at 116

organizations in Europe, North America, and Asia shows

that:

66 percent reported that business benefits were either

only partially realized or not delivered at all.

More than half (55 percent) of benefits rated as highly

important had not been fully realized.

15 percent of respondents were thinking of bringing

services back in-house.

Rising Negative Sentiment in the Media, Analysis of a Sample of 50 Problem Deals,

and Other Surveys Prove that the Tide Is Turning in the Outsourcing Market.


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Faced with unfavorable outsourcing economics and

rigidity, organizations are insourcing and renegotiating

to regain control, negatively impacting their human

resources and supply chain strategies.

83 percent of the participants renegotiated their contracts

in response to changes in prices and to the business,

technology, or regulatory environment.

17 percent cited loss of flexibility as a major risk

introducing rigidity and friction into the organizational

value chain, thus impacting corporate growth and thespeed and quality of service delivery.

Large-scale insourcing and/or renegotiation require

significant senior management commitment, diverting

attention from core business functions.

- Organizations need to train or hire experienced

managers with superior negotiation skills.

- Re-integrating outsourced business functions requires

hiring knowledgeable staff and often changing human

resources practices.

- High vendor turnover and changing conditions forservice delivery often forces companies to modify their

supply chain procedures, adding complexity.

Have You Brought Any Outsourced Services Back In-House?


Yes64%

No36%

Greater price transparency will result in lower vendor

margins, making outsourcing a less attractive option

and compelling the vendors to reposition their best

resources to other growth opportunities.

81 percent of the participants, when queried, said that they

had limited or no transparency to vendor pricing and cost

structure. However, 60 percent of participantsdesired to

learn more about vendor costs.

Approximately one-third of the participants who have

transparency felt that vendor margins may decrease in thefuture.

Commentary suggested that the procurement power of

large buyers will motivate vendors to provide more price

transparency.

Faced with rising instances of deal failure, both vendors and

organizations will become moreselective about entering

into outsourcing contracts.

A notable academic expert commented that the era of

big deals is over. 6

IBM is shifting to technology service contracts that areshorter and smaller in scope than its big traditional

outsourcing deals.7

Switching cost and lack of choice in selecting vendors will

compel organizations to exercise caution when planning

outsourcing.

As outsourcing contracts become less profitable, vendors

will steer their investments and best resources to other,

more lucrative opportunities.

- Vendors are not always ready to take on the next clients.

If their profitability is threatened the vendors may declare

they are under duress, demand ransom, and then cut

services to improve profitability on other deals.

Large Organizations Are Managing Margins and Demanding More from Vendors, but

Large-Scale Insourcing and Reduced Choice of Providers Will Erode the Allure of

Outsourcing.

Vendors and organizations have inherently

conflicting objectives.


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Outsourcing generates fundamental risks and

concerns, more than half of which are

structural and cannot be fully mitigated.

Companies are concerned about intellectual

property and confidentiality risks, loss of

institutional knowledge, and loss of control

over outsourced functions.

Outsourcing often reduces an organizationsresponsiveness to market changes and poses

internal political, organizational, and cultural

challenges.

Structural risks shift bargaining power to the

vendors, while contracts often provide limited

protection.

Structural Risks

8


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Outsourcing Generates Fundamental Risks and Concerns, More than Half of Which

Are Structural and Cannot Be Fully Mitigated.

Companies are exposed to fundamental outsourcing

risks and are facing go/no-go challenges as new risks

emerge.

45 percent stated that an organization should not outsource

processes that it does not fully understand. Two participants

emphasized that outsourcing without fully understanding

the organizations processes and cost structure is extremely

risky because the organization will not know what to

demand from vendors and how much to pay.

1 in 4 participants brought back functions after realizing

that they can do it better and/or at lower cost

in-house.

10 percent of participants expressed concern about limited

transparency and an increased lack of control due to

vendors subcontracting.

Global companies often are unable to find global vendors to

provide standardized services across the different regions,

driving them to employ multiple vendor relationships or

scale back outsourcing objectives.

17 percent of participants mentioned the new Sarbanes-

Oxley requirements as an added layer of complexity to the

already difficult governance of outsourcing deals, creating a

new unexplored risk frontier.


Vendor Underperformance


35%

Loss of Control 35%

Cost-Related (Not Hidden Costs) 30%

Knowledge Loss 30%

Intellectual Property/Confidentiality

Hidden Costs 22%

Governance 22%

Internal Employee Issues 22%

Vendor Employee Turnover/Training 22%

Loss of Flexibility 17%

Loss of Bargaining Power 17%

26%

StructuredRisk

Non-structuralRisk

Risks Cited


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Companies Are Concerned About Intellectual Property and Confidentiality Risks,

Loss of Institutional Knowledge, and Loss of Control Over Outsourced Functions.

Outsourcing increases the risks of intellectual property

violation and loss of confidentiality.

26 percent of the participants view intellectual property and

confidentiality issues as leading risks of outsourcing.

Outsourcing IT infrastructure such as IT Systems

Administration allows vendors to access confidential

business information.

Its important to keep intellectual capital close to

the chest.

10 percent of the participants experienced confidentiality

and intellectual property rights violations.

One participant discovered its vendor selling its

proprietary software to other clients.

However this is a tough risk to mitigate: This is very

troubling, and I have to constantly keep a watch on my

vendors.

The risk of losing institutional knowledge is greater

when outsourcing thought leadership functions and

can be partially mitigated by outsourcing onlycommodity processes.

30 percent of the participants view the loss of institutional

knowledge as a leading risk of outsourcing.

We came up with a rule: If it is a rule-based process, it

can be outsourced; if it is a decision-based process, it is

not to be outsourced.

Nearly 20 percent of the participants outsourced functions

they later recognized as thought leadership and

containing imbedded strategic knowledge, acknowledged

their mistake, and brought operations back in-house.

Now that we are bringing the function back in-house,we are dependent on vendor cooperation to transfer the

knowledge.

Loss of control over outsourced functions poses a

substantial threat to ongoing operations.

30 percent of the participants viewed loss of control over

outsourced functions as a substantial risk.

Avoid outsourcing lock, stock, and barrel, in order to

maintain control (over our value chain).

Participants are bringing outsourced functions back in-

house because they realize they have lost control over

critical processes. Too much outsourcing results in lack of control.

Companies should not outsource key areas where

losing control can be disastrous.


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Outsourcing Often Reduces Organizations Responsiveness to Market Changes and Poses

Internal Political, Organizational, and Cultural Challenges.

Multi-year contracts result in a loss of flexibility to react

to market changes, hurting companies competitiveness.

1 in 6 participants are concerned about the loss of flexibility

to react to changes in the market (e.g., competitive,

regulatory), as a result of being locked into multi-year deals.

Vendors push for long-term deals to recoup initial

investments and make profits. When pressed to shorten

deal length, prices increase.

We buy flexibility with shorter term deals, even thoughthey are clearly more expensive.

There is an explicit trade-off between maintaining

flexibility and lowering cost.

circumstances change, and we cant afford to get

locked into a bad deal.

Outsourcing negatively impacts organizational cohesion

by posing political, organizational, and cultural

challenges in all stages, from decision-making through

implementation.

1 in 4 participants have struggled with internal politics and

conflicts surrounding their outsourcing decisions.

1 out of 6 participantsidentified employee backlash and

active labor unions as substantial obstacles.

Employees are never going to accept outsourcing. It willbe their choice to stay or leave.

40 percent of the participants dealt with organizational

challenges that follow outsourcing, primarily reorganizing

roles and responsibilities and raising the skill sets of the

retained organization.

Managers who were trained to run day-to-day

operations now need to learn to manage results and

vendors.

Companies must take into account the significant

amount of time it takes for employees to get accustomed

to changes.


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Structural Risks Shift Bargaining Power to the Vendors, While Contracts Often Provide

Limited Protection.

Structural risks lead to a shift of bargaining power from

the organization to the vendor.

1 in 5 participants have explicitly identified the loss of

bargaining power as a major outsourcing risk.

Handover of control and knowledge to the vendor creates

an ongoing dependency on the vendor. This dependency

ultimately shifts power to the vendor and weakens the

organization.

Once an organization has gone through the process ofadjusting its retained organization and its skill sets, it no

longer holds the capabilities and skill sets to manage

these functions in-house, increasing dependency on the

vendor.

Long-term contracts and proprietary systems further

increase vendors bargaining power.

Long-term contracts (six-ten years) substantially increase the

risk of shifting bargaining power to the vendor.

We dont do a lot of outsourcing because the vendors

are hung up on long-term commitments, like 5 years.

They are putting a large investment, so they need thelong term, but thats quite a leap of faith, putting

yourself in the hands of someone for 5 years.

once you hand over maintenance its not easy to take

it back.

Vendors might lock companies into using proprietary

systems, making it difficult to switch vendors in the future.

One participant reported changing its vendor on a large

infrastructure contract when it observed that the vendor

was trying to gradually integrate it into proprietary

systems.

Organizations are trying to offset this trend by

negotiating shorter-term, more flexible contracts and by

working with multiple vendors.

53 percent of the participants have moved from long-term

contracts (6-10 years) to shorter contracts (up to five years).

None of the participants that currently have long-term

contracts expect them to go to full-term.

73 percent of the participants are working with multiple

vendors. Participants that had exclusive deals in the pastwarn that they are extremely risky and that they will never

enter into them again.

My vendors always know that they could lose the

business any day, or there is more business to win every

daythey make the choice; our vendors have to earn our

business every day.

However, these mitigation strategies provide limited

protection.

Even short-term deals (less than three years) often create

high dependency on vendors, holding organizations

captive.

Second sourcing (wherein two outsourcers provide

services to forestall monopoly pricing power) is difficult

with services outsourcing. Multi-vendor models increase

the level of complexity, requiring additional resources from

the organization.

Vendor dependency cannot be fully mitigated because the

organization no longer owns the functions, knowledge,

people, and systems.

And, organizations then find themselves trapped in

deals with higher rates and low-quality delivery. The vendors bargaining power becomes evident in contract

renegotiations or renewals, and the organization is forced

to adhere to the vendors terms or incur high switching

costs. Specific consequences that were mentioned:

Being trapped in a deal with above-market rates

Diminishing service standards

Four participants indicated that vendors force contract

renegotiation to increase their profitability, leading to

higher rates.


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Outsourcing, which originated as a popular

cost-saving strategy during a recessionary

economic environment, is still dominantly

driven by cost-related objectives and the

perception that organizations benefit from

vendors economies of scale.

However, evidence of tailored deals and in-

house economies of scale at largeorganizations suggests that vendors scale

advantages may be illusory.

Lack of transparency, bundling of services,

and a variety of marketing techniques have

created suspicion about the savings from

outsourcing.

Real-world experiences suggest that the

potential for cost savings has been overstated.

Costs


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Outsourcing, Which Originated as a Popular Cost-Saving Strategy During a Recessionary

Economic Environment, Is Still Dominantly Driven by Cost-Related Objectives and the

Perception that Organizations Benefit from Vendors Economies of Scale.

Recent surveys suggest that outsourcing is no longer

driven primarily by cost, but instead by the desire to

gain expertise and increase quality.

A 2004 The Earth Institute/Columbia University outsourcing

study found that 62 percent of the companies surveyed are

outsourcing because of a desire to improve the quality of

services.8

A 2004 Bureau of National Affairs survey of human

resources outsourcing found that gaining access to greaterexpertise (69 percent) and improving service quality (44

percent) are the top two reasons to outsource. Only 28

percent of respondents mentioned cost-cutting as a main

driver.9

However, our findings suggest that outsourcing is still

highly driven by cost savings objectives

83 percent of participants mentioned cost savings as an

expected benefit of outsourcing.

70 percent of participants cited cost savings as one of the

key drivers of outsourcing.

43 percent of participants declared cost savings as the

primary criterion for choosing a vendor.

And that organizations believe cost savings are

delivered mostly through vendors economies of scale.

Vendors can leverage highly specialized resources and

infrastructure, giving the organizations the flexibility to

scale up and down rapidly.

In addition, vendors have economies of scale in knowledge,

which allow them to:

Add value to the organizations by providing access to

new ideas

Provide cheaper services, even after factoring in profit

margins

Vendors Perceived Structural Advantages


Economies of Scale

Capabilities 48%

Knowledge/Experience

39%

Skilled Labor26%

Innovation 13%

Flexibility 4%


70%


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However, Evidence of Tailored Deals and In-house Economies of Scale at

Large Organizations Suggests that Vendors Scale Advantages May Be Illusory.

Large outsourcing deals are typically tailored,

eliminating the vendors ability to standardize contracts

to deliver economies of scale.

100 percent of participants have tailored outsourcing deals.

Vendors find it difficult to offer standardized services to

complex organizations.

As the need to tailor contracts increases, the vendors

ability to deliver savings based on economies of scale

decreases.

If a project needs customizing, it should not be subject

to outsourcing.

It is uncertain that there are economies of scale to be

gained by large organizations that already realize some

economies of scale in-house.

48 percent of participants agreed or partially agreed that

few vendors (except infrastructure vendors) have economies

of scale greater than those of large companies.

43 percent of participants agreed or partially agreed that

large, well-run companies have resources, both technical

and managerial, to efficiently run outsourced functionsthemselves.

The benefits of the economies of scale argument are

relative. Fortune 100-300 IT departments may benefit

more from economies of scale in IT at large IT outsourcing

vendors than those at Fortune 50.10

Uncertain gains from vendors economies of scale suggest

that additional cost savings may not be enough to counter

the risks of outsourcing.

How Standardized or Tailored Are Your Outsourcing Deals?


Tailored76%

Some Standardized/Some Tailored

24%

Note: Seventeen percent of the participants indicated a shift toward morestandardized agreements (terms and conditions, legal, etc.)


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Real-World Experience Suggest That the Potential for Cost Savings Has Been Overstated.

Organizations are becoming aware of cost-related risks.

52 percent of participants ranked cost-related issues as the

main risks of outsourcing.

42 percent of the cost-related risks correspond to hidden

costs and/or transparency.

Vendors give clients better deals until years three or four;

after that they begin exploiting the clients.

Cost-Related Risks of Outsourcing

Other*24%

Hidden Costs/Transparency

42%

Vendor SelectionCosts17%

*Other cost-related risks included vendor profit margins, trade-off between qualityand cost savings, among others

Vendor Management

Costs17%


And are experiencing hidden costs.

50 percent of participants identified hidden costs as the

most common problem when managing outsourcing deals.

44 percent of participants did not see cost savings

materializing.

50 percent of participants with limited or no transparency

have paid additional costs in their outsourcing relationships.

57 percent participants have paid additional costs forservices they thought were included in the contract.

Unexpected costs are almost guaranteed. I have not

executed any deal without them.

After accounting for the vendors raw cost, contract

administration, profit margins, and in-house

management, outsourcing does not always make

economic sense.

62 percent of participants realized that they require more

management efforts in comparison to the original estimates.

57 percent of participants could not free up internal

resources for other projects, leading to larger than

anticipated deal management overhead. One participant

reported a 300 percent larger retained organization than

anticipated.


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Participants recognize the need for

improvement in decision-making, but

attempts to standardize the business case,

improve due diligence, and increase

transparency often are not used for new

contracts or are too late for existing contracts.

Outsourcing relationships require

substantially more recordkeeping, attention,

and hands-on management than anticipated.

Vendor complacency, employee turnover,

unsatisfactory delivery resources, and

unbalanced contracts have prompted

organizations to increase their demands, and

vendor management continues to pose

challenges.

Organizational

Complexity


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Participants Recognize the Need for Improvement in Decision-Making, but Attempts to

Standardize the Business Case, Improve Due Diligence, and Increase Transparency Often

Are Not Used for New Contracts or Are Too Late for Existing Contracts.

Participants have mixed levels of analytical

preparedness, knowledge, and negotiating ability

resulting in a lengthy, problem-prone, and highly

politicized decision-making process.

48 percent of participants do not have a standardized

methodology to evaluate the business case for outsourcing.

26 percent indicated a need for different skills, with greater

emphasis on negotiation, relationship development, and

maintenance. Existing management that organizations predominantly

rely on to drive the outsourcing process faces a complex

set of factors balancing operational improvement,

contract management, capital expenditure, human

resources dynamics, and developing new metrics and

multi-year cost-reduction targets with vendors the sum

of which are often outside the realm of their experience.

24 percent stated the outsourcing decision, from business

case to procurement, is a very lengthy process, ranging

from six months to two years to complete.

Participants are standardizing decision-making

methodologies and demanding more transparency, but

these changes are often not used for new contracts or

are too late for existing ones.

27 percent of participants indicated a shift toward a more

standardized business case for future decisions; however,

they realize that standardization will be difficult because

they have limited experience with outsourcing.

33 percent recognized a need for a more complete duediligence process.

We have increased the level of up-front due diligence

not just cost baseline, but delivery and qualitative

outcomes.

Half of the participants with limited or no knowledge of

their vendors pricing structures are demanding more

transparency in an attempt to ensure proper vendor

selection.

All of these efforts result in changes to the governance

process and future deals, but do not affect the contracts

that are already in place, raising the spectre of unknown

and future problems in managing their current portfolio of

deals.

What Methods Are Used to Analyze and Justify the Decision toOutsource?


CompetitiveBidding

10%

NPV/ROICost Payback

52%

No FormalMethodology

10%

Case-by-CaseAnalysis

28%


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Outsourcing Relationships Require Substantially More Recordkeeping, Attention,

and Hands-On Management than Anticipated.

Managing outsourcing contracts and relationships is

more difficult, more expensive, and more time

consuming than anticipated.

62 percent of participants stated that managing

outsourcing relationships requires more effort than

anticipated.

Everything takes longer than you plan.

Outsourcing has created more work for many of our

peoplemore governance related to security issues andcontractual dynamics...bad from a management

perspective.

Participants manage contracts up to 10,000 pages in

length, making the ability to check on vendor adherence to

all contract clauses nearly impossible.

This leads to unplanned senior management

involvement and up to a 300 percent larger retained

organization than anticipated.

Although 39 percent of participants expressed realignment

of resources as a key benefit of outsourcing, 44 percent of

those participants have yet to realize this benefit.

17 percent of the participants have added or are currently

adding resources for relationship management and

maintenance. Vendors make mistakes and we have to pick up after

them.

Commentary revealed that because of insufficient due

diligence, participants underestimate the number of

resources and the effort required to manage the retained

organization.

75 percent of participants described multi-layered

governance structures and, of those participants, 42

percent have dedicated resources for each vendor

relationship, further complicating reporting relationships.

Participants stated that often they dedicate too few

resources to deal management and are later forced to

develop larger vendor management teams that result in

more complex, multi-layered governance structures.


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Vendor Complacency, Employee Turnover, Unsatisfactory Delivery Resources,

and Unbalanced Contracts Have Prompted Organizations to Increase Their Demands,

and Vendor Management Continues to Pose Challenges.

Complacency, turnover, average delivery resources

and vendor self-reported Service Level Agreements

(SLAs) have often dictated the course of outsourcing

relationships, stacking the deck in favor of the vendor.

1 in 5 participants stated that unless pressured, vendors

become complacent and fail to provide innovative solutions

and process improvements once contracts are in place.

22 percent experienced vendor employee turnover, leading

to knowledge loss and interrupted service delivery.

Three large participants noticed a significant difference in

quality between their vendors sales people and

delivery people.

While sales and marketing representatives perform well,

the operations teams often perform at par or slightly

above the level at which the organization previously

performed the function.

1 in 10 participants indicated that subcontracting by

vendors leads to an increased lack of control and creates a

system in which accountability issues more readily arise.

1 in 7 participants expressed frustration with determining

and measuring SLAs, and experiences have indicated that

vendors can twist the numbers to protect themselves.

In response, participants have been forced to include

gain-sharing incentives and more stringent quality and

service requirements in their contracts.

45 percent of participants feel compelled to include gain-

sharing clauses in contracts as motivation for innovation.

81 percent include provisions for regular updates and active

involvement in governance meetings.

Organizations are demanding better training and

development programs for vendor employees, as well as

increased investment in back office systems; the goal is to

improve the retention of talent and decrease the likelihood

of errors and service disruption.

These changes increase the total cost of the deal and do

not provide protection against loss or leverage when

managing experts.

More stringent demands require more resources, time, and

money increasing the total cost of the deal.

Metrics and contractual clauses meant to protect the

organization often provide limited benefits.

Organizations attempts to manage experts may not

always be successful, as vendors have deeper domain

expertise of the outsourced functions and are experts at

structuring deals in their favor.

I believe that 50 percent of outsourcing in the near

future will be successful, with the failures stemming from

clients that dont know what they are doing, dont

understand outsourcing, or dont understand their own

business. Therefore, they dont know how to structure

and manage the deals.


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22


Services outsourcing has evolved from

product (manufacturing) sourcing, but

fundamental differences have been

overlooked and are coming to the fore.

While 30 percent of participants have

encountered normal outsourcing growing

pains, 70 percent of participants have had

significant negative experiences and are

outsourcing with increasing caution and in a

conservative manner.

Outsourcing, as we know it, will increasingly

lose luster. Vendors and organizations will

become more selective about the deals they

pursue.

However, outsourcing will remain a useful

solution within the conservative context of

the following five models: centralize-

standardize-outsource, transform-operate-

transfer, commodities outsourcing, risk

transfer, and shifting fixed costs to variable

costs.

Conclusions


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2


Services Outsourcing Has Evolved from Product Sourcing, but Fundamental Differences

Have Been Overlooked and Are Coming to the Fore.

Measuring quality is standardized in product sourcing,

yet it is tricky in services outsourcing.

Product (Manufacturing) Sourcing

Products are tangible; therefore, measuring quality is more

straightforward and standardized:

Predetermined quality standards (such as works/does not

work, deviation from size).

Defined measures (such asxpercent defects per batch).

Services Outsourcing

Services are intangible, making it more challenging to

measure quality.

91 percent of participants have SLAs in place. There is a

trade-off between qualitative and quantitative metrics.

Qualitative metrics are difficult to implement; therefore,

companies resort to quantitative ones, which often fail to

measure true quality.

Outsourced services are highly interdependent


Products are discrete by nature, and interdependencies are

fewer and well defined.


Services are a continuum and have many interdependencies.

These interdependencies are difficult to maintain when

outsourced, leading to blind symphony (a condition

created when too many organizational processes are

outsourced and the organization is unable to function

cohesively).

Requiring tight ongoing cooperation with vendors.


Relationships typically take the form of supplier-buyer.

Relationships with different suppliers are independent of

one another.


The high interdependence of services requires closer

working relationships with every vendor and among

vendors, increasing the complexity of the relationships and

requiring far more management resources than product

outsourcing.

Second sourcing, while common in product sourcing, is

unsuitable for services outsourcing, leading to higher

dependency on the vendors.


Second sourcing (using more than one vendor for the same

product) is a common practice with product manufacturing:

As a contingency

To increase bargaining power vis-a-vis the vendors


Second sourcing is often unsuitable for services outsourcing,

as a company would not benefit from having two vendors

for services such as IT infrastructureorbusiness functions.

Relying on a single vendor per service, and the

interdependencies among the different services, create high

dependency on vendors for continuing operations.

The result: complexity in place of simplicity.


Product sourcing simplifies the value chain, allowing

companies to become developers, marketers, and managers

of the supply chain.


Outsourcing several functions to simplify operations results

in a reverse effect; it increases the number of deals and

vendors, resulting in increased complexity in all stages of the

value chain from strategy to execution.


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While 30 Percent of the Participants Have Encountered Normal Outsourcing Growing

Pains, 70 Percent Have Had Significant Negative Experiences and Are Outsourcing with

Increasing Caution and in a Conservative Manner.

30 percent of participants have encountered normal

growing pains, but 43 percent of these are new to

outsourcing and likely to have problems down the road.

30 percent of the participants expressed satisfaction or

normal growing pains with outsourcing. These

participants faced one or no problems, with the most

common being internal challenges.

43 percent of these participants have just recently begun to

outsource and it may be difficult for them to make an early,conclusive evaluation of their outsourcing experiences.

70 percent of the participants have had negative

outsourcing experiences and have either revised or are

revising their outsourcing outlook, strategies, and

tactics. These are the more experienced organizations

and they will continue to move forward with

outsourcing but with increased scrutiny.

70 percent of participants have had unsatisfactory

outsourcing experiences, encountering two to ten

problems.

52 percent encountered two to four problems.

18 percent encountered five or more problems.

Outsourcing has caused us to lose focus on our core

businessit has been more of a distraction than a

benefit!

100 percent of participants that faced more than five

problems have gone through insourcing.

Commentary revealed that the insourced functions are

often run at a lower cost and higher quality.

In two instances, participants were subjected to problem

escalation provisions. In one case, litigation was pursued,and in the second case the vendors violations were used as

leverage to improve contractual terms.

Despite these problems, most participants intend to

continue outsourcing and are implementing lessons learned

from past deals:

Clear definition of core and strategic functions that are

not to be outsourced to retain competitive advantage.

Short-term contracts with renegotiation and cancellation

clauses, and with comprehensive SLAs in place, including

both quantitative and qualitative metricsto maintain

flexibility and avoid vendor complacency.

Working with multiple vendors to reduce vendor

dependency.

A standardized process of planning and decision-making.

Realistically planning governance systems involving the

vendors, and budgeting resources and time for deal

management to minimize operational complexity.

Problems Faced by Participants with Negative Experiences


Complex Governance/Management Attention 56%

ChangeManagement 56%

Quality/DeliveryIssues

38%

Limited Transparency 38%

Loss of Knowledge 31%

Cost SavingsQuestioned 31%

Escalation 31%


Hidden Costs

Locked in Deals/No Flexibility

19%

Large RetainedOrganization

19%

VendorComplacency 19%

Vendor EmployeeTurnover/Training

19%

High SwitchingCosts

19%

25%


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2


Outsourcing, as We Know It, Will Increasingly Lose Luster. Vendors and

Organizations Will Become More Selective About the Deals They Pursue.

Outsourcing will lose holy grail status.

In the future, companies will not outsource because it is the

latest management fad, and it is the thing to do.

Vendors will become more selective in choosing new clients

to avoid taking on mess for less.

Organizations will outsource less

Organizations will carefully define core, strategic, and

thought-leadership functions and will keep those inhouseto retain knowledge, confidentiality, and control over key

functions. Some organizations will decide to outsource only

short-term using the Transform-Operate-Transfer model.

As a result of outsourcing only commodity processes or

outsourcing temporarily for a transformation, organizations

will outsource a smaller percentage of their operating

expenses.

Many organizations will also engage in large scale re-

insourcing thereby further eroding the outsourcing market.

...And more conservative outsourcing will erode vendor

margins.

Organizations attempts to manage margins and increase

the level of caution when outsourcing will lead to shorter

contracts and a squeeze on profit margins of large

providers.

Vendors will continue to rationalize services, cost structure,

and pricing.


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However, Outsourcing Will Remain a Useful Solution Within the Conservative

Context of These Five Models.

Centralize-Standardize-Outsource

Initially, organizational processes that have been targeted

for outsourcing are centralized and standardized, allowing

the company to achieve efficiencies internally and to gain

detailed management insights into processes and costs.

Newly-achieved efficiencies allow visibility into potential

outsourcing business cases.

Increased management insight into the functions enables

clear definition of operational and cost demands from

vendors.

These companies will engage in typically lower levels of

outsourcing, and will keep most cost savings in-house

rather than sharing them with the vendor.

Transform-Operate-Transfer

Organizations employ vendors to transform a function and

to run it for a short-term period.

Transformations are often more easily achieved externally

than internally; thus, the benefits outweigh short-termoutsourcing costs.

This model is relevant especially for companies in volatile/

fast-moving industries, where rapid changes and

adjustments are required.

Commodities Outsourcing

Companies will pursue outsourcing of non-core, non-

strategic, and non-differentiating functions (e.g., Web-

hosting and mailroom services).

Companies will outsource these types of functions to

vendors that specialize in these areas. The vendors

economies of expertise suggest the vendor will better

manage and run these functions.

Risk Transfer (Insurance)

Outsourcing functions, such as disaster recovery, enables

organizations to spread the operational and financial risk

for functions that they are less able to perform in-house,

providing insurance-like protection.

Shifting Fixed Costs to Variable Costs

In human and financial capital intensive areas, such as legal

or infrastructure, vendors offer organizations economies of

scale and flexibility, allowing the shift from fixed costs to

variable costs.


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2


Appendix: Literature Sentiment IndexLiterature Sentiment Index

Source: Business Week, The Economist, Forbes, Fortune, The Wall Street Journal,and The Washington Post

120

100

80

60

40

20

01999 2000 2001 2002 2003 2004


Pro-Outsourcing Articles

Balanced

Anti-Outsourcing Articles

Informative

Numberof Articles

Approach For the period January 1, 1999 through December 15, 2004, all articles

with significant mention of outsourcing and published in the followingsix leading journals were read and rated: Business Week, The Economist,Forbes, Fortune, The Wall Street Journaland The Washington Post(more than 570 items)

Each article was rated on whether it was pro-outsourcing, anti-outsourcing,balanced, or informative-only

Results were tabulated and graphed

LexisNexisNegative Phrase Search Results

Source: LexisNexis

300

250

200

150

100

50

01999 2000 2001 2002 2003 2004


Occurrence of NegativePhrases Associatedwith Outsourcing

Approach For the period January 1, 1999, through December 15, 2004, LexisNexis

was searched for instances of 13 stock phrases, indicating sentimentagainst outsourcing (e.g., outsourcing failures, outsourcing controversy)

These findings were compiled and graphed

35 4054

47

67

264


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28


Appendix: Analysis of Problem DealsProblem Deals Breakdown by Outsourcing Type

Source: Randomly Chosen 50 Problematic Outsourcing Deals from LexisNexis,

Factiva and Proquest

Sample skewed towards BPO, possibly indicating either that BPO dealsfail more often (they are a newer type of contract) or that the BPOfailures are well-publicized

AMO18%

IT Infrastructure42%

BPO40%

Problem Deals Breakdown by Deal Value

Source: Randomly Chosen 50 Problematic Outsourcing Deals from LexisNexis,

Factiva and Proquest

500

Reported Value of Deals $million

Sample is dominated by problematic deals that are large in size (over

$100M). While bigger deals may fail more often than smaller ones, it ismore likely that larger failures tend to be publicized more often Estimations based on available public information for 24 of the 50 deals

in the sample

4

1

7

12

Numberof Deals

Problem Deals Breakdown by Timing of Problem

Source: Randomly Chosen 50 Problematic Outsourcing Deals from LexisNexis,Factiva and Proquest

10

Reported Number of Years When ProblemOccurred (After Deal Implementation)

Most deals for which the timing is known, fail in the first year (11) or firstfive years (16). This is consistent with other research, such as Dun &Bradstreet (2002).

Estimations based on available public information for 33 of the 50 dealsin the sample.

11

16

5

1

Numberof Deals

Of 50 Problematic Outsourcing Deals Reported in the Media, 76Percent Ended Up in Deal Termination or Litigation


Litigation32%

DealTermination

44%

Deal at Risk

20%Negotiations

Called Off4%


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2


Underperformance and Cost Overruns Are the Key Drivers ofOutsourcing Problems

Source: Randomly Chosen 50 Problematic Outsourcing Deals from LexisNexis

,Factiva and Proquest

Other6%

Underperformance59%

Cost Overruns15%

Labor StandardViolations/

Labor Unrest8%

Fraud4%

IntellectualProperty Issues

8%

Key Issues Underlying Underperformance*


Outsourcer Over-expectations

Poor Management

45%

Lack ofSkills/Expertise

35%

35%

Technology Problems 24%

*Given that failures have multiple related causes, the total number ofcauses may be greater than 100 percent

Key Issues Underlying Cost Overruns*


Hidden costs andTeaser Rates

DemandManagement

50%

Inflexibility ofcontracts

25%

13%

Disagreement OverCost Metrics Used

13%

*Given that failures have multiple related causes, the total number ofcauses may be greater than 100 percent

Appendix: Analysis of Problem Deals, continued


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30


1 Publications included The Economist, The Wall Street

Journal, Forbes, Fortune, The Washington Post, and

Business Week.

2 LexisNexisstock phrases: outsourcing failure, outsourcing

failures, outsourcing scandal, outsourcing scandals,

outsourcing lawsuit, outsourcing lawsuits, outsourcing

losses, outsourcing fraud, outsourcing controversy,

outsourcing risk, outsourcing risks, outsourcing problem,

outsourcing problems.

3 Dun & Bradstreet Survey 2002.

4 (http://www.cio.com/archive/030103/home.html).

5 (http://www.paconsulting.com/news/press_release/2003/

pr_20030303.htm).

6 Dr. Eric Clemons, PhD., Professor of Operations and

Information Management and Management, Wharton

School of the University of Pennsylvania.

7 The Wall Street Journal, p. 1, Whats News, 2/24/05.

8 Jobs Offshored for Cost Savings and Quality, The Earth

Institute, Columbia University, July 22, 2004, New York, NY(http://www.earth.columbia.edu/news/2004/story07-22-

04.html).

9 Cost-Cutting Is Common but Not Critical in Outsourcing

Decisions, Major Survey of Human Resources Executives

Finds, The Bureau of National Affairs Inc., July 15, 2004,

Washington, D.C. (http://www.bna.com/press/2004/

outsource04.htm).

10 Dr. N. Venkatraman, David J. Mcgrath Jr. Professor of

Management, Chairman IS Department, Boston University.

Endnotes


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3


Contact Information

Core Study Team Members

Kenneth M. Landis

Principal, Strategy & Operations

Deloitte Consulting LLP

New York, NY

Tel: 212.618.4800

Email: [email protected]

Somnath Mishra

Manager, US Federal Practice

Deloitte Consulting LLPWashington, DC

Tel: 202.378.5453


Kenneth Porrello

Principal, Strategy & Operations

Deloitte Consulting LLP

Chicago, IL

Tel: 312.374.3076


For more information about this study, contact us via Email:

[email protected].

Acknowledgments

Deloitte Consulting is grateful for the contributions from

the following:

Dan Alamariu, Senior Consultant

New York, NY

Tel: 212.618.4179


Keiichi Aritomo, Senior Manager

New York, NYTel: 212.618.4352


Tiffany Chung, Consultant

New York, NY

Tel: 212-618-4542


Shirley Cohen-Mintz, Senior Consultant

New York, NY

Tel: 212.618.4736


Yasuko Nakaba, Senior Consultant

New York, NY

Tel: 212.618.4746


Vikrant Saraswat, Senior Consultant

New York, NY

Tel: 212.618.4754


Francisca Villegas, Senior Consultant

New York, NY

Tel: 212.618.4231Email: [email protected]

Natalie Vitiello, Consultant

New York, NY

Tel: 212.618.4518



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As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each others acts or omissions.Each of the member firms is a separate and independent legal entity operating under the names Deloitte, Deloitte & Touche, Deloitte ToucheTohmatsu, or other related names.

In the United States, Deloitte & Touche USA LLP is the member firm of Deloitte Touche Tohmatsu, and services are provided by the subsidiaries ofDeloitte & Touche USA LLP (Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP, and their subsidiaries) and not by Deloitte & Touche USALLP. The subsidiaries of the U.S. member firm are among the nations leading professional services firms, providing audit, tax, consulting, and

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